1. Employee Stock Options: Introduction
  2. Employee Stock Options: Definitions and Key Concepts
  3. Employee Stock Options: Comparisons To Listed Options
  4. Employee Stock Options: Valuation and Pricing Issues
  5. Employee Stock Options: Risk and Reward Associated with Owning ESOs
  6. Employee Stock Options: Early Or Premature Exercise
  7. Employee Stock Options: Basic Hedging Strategies
  8. Employee Stock Options: Conclusion

As a way to reduce risk and lock in gains, early or premature exercise of Employee Stock Options (ESOs) must be carefully considered, since there is a large potential tax hit and big opportunity cost in the form of forfeited time value. In this section, we discuss the process of early exercise and explain financial objectives and risks.

When an ESO is granted, it has a hypothetical value that – because it an at-the-money option – is pure time value. This time value decays at a rate known as theta (Related: Using the “Greeks” to understand options), which is a square root function of time remaining.

Assume you hold ESOs that are worth $35,000 upon grant, as discussed in the earlier sections. You believe in the long-term prospects of your company and plan to hold your ESOs until expiration. Figure 3 shows the value composition – intrinsic value plus time value – for ITM, ATM and OTM options. 

Value Composition for In, Out and At the Money ESO Option With Strike of $50 (Prices in Thousands)
Figure 8: A hypothetical ESO option with the right to buy 1,000 shares.The numbers have been rounded to nearest thousandth

Even if you begin to gain intrinsic value as the price of the underlying stock rises, you will be shedding time value along the way (although not proportionately). For example, for an in-the-money ESO with a $50 exercise price and a stock price of $75, there will be less time value and more intrinsic value, for more value overall (top bars in Figure 3). (Related: The Importance Of Time Value In Options Trading)

The out-of-the-money options (bottom set of bars) show only pure time value of $17,500, while the at-the-money options have time value of $35,000. The further out of the money that an option is, the less time value it has, because the odds of it becoming profitable are increasingly slim. As an option gets more in the money and acquires more intrinsic value, this forms a greater proportion of the total option value. In fact for deeply in-the-money option, time value is an insignificant component of its value, compared with intrinsic value. When intrinsic value becomes value at risk, many option holders look to lock in this all or part of this gain, but in doing so, they not only give up time value but also incur a hefty tax bill.

Tax Liabilities for ESOs

We cannot emphasize this point enough – the biggest downsides of premature exercise are the big tax event it induces, and the loss of time value. You are taxed at ordinary income tax rates on the ESO spread or intrinsic value gain, at rates as high as 40%. What’s more, it is all due in the same tax year and paid upon exercise, with another likely tax hit at the sale or disposition of the acquired stock. Even if you have capital losses elsewhere in your portfolio, you can only apply $3,000 per year of these losses against your compensation gains to offset the tax liability.

After you have acquired stock that presumably has appreciated in value, you are faced with the choice of liquidating the stock or holding it. If you sell immediately upon exercise, you have locked in your compensation “gains” (the difference between the exercise price and stock market price).

But if you hold the stock, and then sell later on after it appreciates, you may more taxes to pay. Remember that the stock price on the day you exercised your ESOs is now your “basis price.” If you sell the stock less than a year after exercise, you will have to pay short-term capital gains tax. To get the lower, long-term capital gains rate, you would have to hold the shares for more than a year. You thus end up paying two taxes – compensation and capital gains.

An Example

Many ESO holders may also find themselves in the unfortunate position of holding on to shares that reverse their initial gains after exercise, as the following example demonstrates. Let’s say you have ESOs that give you the right to buy 1,000 shares at $50, and the stock is trading at $75 with five more years to expiration. As you are worried about the market outlook or the company’s prospects, you exercise your ESOs to lock in the spread of $25.

You now decide to sell one-half your holdings (of 1,000 shares) and keep the other half for potential future gains. Here’s how the math stacks up –

  • Exercised at $75 and paid compensation tax on the full spread of $25 x 1,000 shares @40% = $10,000.
  • Sold 500 shares at $75 for a gain of $12,500.
  • Your after-tax gains at this point = $12,500 – $10,000 = $2,500
  • You are now holding 500 shares with a basis price of $75, with $12,500 in unrealized gains (but already tax paid for).
  • Let’s assume the stock now declines to $50 before year-end.
  • Your holding of 500 shares has now lost $25 per share or $12,500, since you acquired the shares through exercise (and already paid tax at $75).
  • If you now sell these 500 shares at $50, you can only apply $3,000 of these losses in the same tax year, with the rest to be applied in future years with the same limit.
  • To summarize:
    • You paid $10,000 in compensation tax at exercise
    • Locked in $2,500 in after-tax gains on 500 shares
    • Broke even on 500 shares, but have losses of $12,500 that you can write off per year by $3,000.

Note that this does not count the time value lost from early exercise, which could be quite significant with five years left for expiration. Having sold your holdings, you also no longer have the potential to gain from an upward move in the stock.

That said, while it seldom makes sense to exercise listed options early, the non-tradable nature and other limitations of ESOs may make their early exercise necessary in the following situations –

  • Need for cashflow: Oftentimes, the need for immediate cashflow may offset the opportunity cost of time value lost and justify the tax impact.
  • Portfolio diversification: As mentioned earlier, an overly concentrated position in the company’s stock would necessitate early exercise and liquidation in order to achieve portfolio diversification.
  • Stock or market outlook: Rather than see all gains dissipate and turn into losses on account of a deteriorating outlook for the stock or equity market in general, it may be preferable to lock in gains through early exercise.
  • Delivery for a hedging strategy: Writing calls to gain premium income may require the delivery of stock (discussed in next section). 

 


Employee Stock Options: Basic Hedging Strategies
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